Why is the acid-test ratio considered more stringent than the current ratio? | TutorChase (2024)

FAQs

Why is the acid-test ratio considered more stringent than the current ratio? | TutorChase? ›

This ratio is considered more stringent or conservative than the current ratio because it excludes inventory, which may not be easily converted into cash. On the other hand, the current ratio includes all current assets, including inventory, in its calculation.

Also called the acid test ratio, a quick ratio is a conservative measure of your firm's liquidity because it uses a fraction of your current assets. Unlike current ratio, quick ratio calculations only use quick assets or short-term investments that can be liquidated to cash in 90 days or less.

However, the acid-test ratio is considered more conservative than the current ratio because its calculation ignores items such as inventory, which may be difficult to liquidate quickly.

Compared to the current ratio – a liquidity or debt ratio which does include inventory value in the calculation – the acid-test ratio is considered a more conservative estimation of a company's financial health. The higher the ratio, the better the company's liquidity and overall financial health.

On the other hand, a high or increasing acid test ratio indicates a company has faster inventory turnover and cash conversion cycles. This ratio happens when a company is experiencing top-line growth, quickly converting receivables into cash, and are easily able to cover its financial obligations.

It is seen as more useful than the often-used current ratio since the acid test excludes inventory, which can be hard to quickly liquidate. In the best-case scenario, a company should have a ratio of 1 or more, suggesting the company has enough cash to pay its bills.

While the Acid-Test Ratio (Quick Ratio) is a valuable metric for assessing short-term liquidity, it has certain drawbacks and limitations that should be considered: 1. Overly Conservative: The Acid-Test Ratio can be excessively conservative by excluding inventory.

The cash ratio is the most stringent of all Liquidity Ratios and measures a company's ability to pay off its short-term debt with only cash or cash equivalents. To calculate this ratio, divide a company's total cash and cash equivalents by its total current liabilities.

The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are generally more difficult to turn into cash. The quick ratio considers only assets that can be converted to cash in a short period of time.

The quick ratio, also known as the acid-test ratio, is a refined liquidity metric designed to offer a more conservative assessment of a company's ability to meet its short-term liabilities without relying on the sale of inventory.

What does the acid test ratio differ from? ›

The acid test ratio differs from the current ratio by not including inventory and prepaid assets in the numerator of short-term assets. The acid test ratio numerator only includes quick assets that are liquid current assets readily convertible to cash.

Acid-test ratio (also known as quick ratio) is a measure of a company's liquidity, which is its ability to pay its short-term obligations using only its most liquid assets. It is calculated by dividing the sum of a company's cash, cash equivalents and marketable securities by its total current liabilities.

With an acid test ratio of at least 1, a company should have adequate liquidity to pay current liabilities when payments are due. The higher the acid test ratio number, the more cash and near-cash liquid assets a company has. The company's ability to pay short-term obligations is more assured.

It is often helpful in more situations than the current ratio as it ignores all the assets that are not easy to liquidate. If the acid test ratio is much lower than the current ratio, it means that there are more current assets that are not easy to liquidate (e.g., more inventory than cash equivalents).

The current ratio weighs a company's current assets against its current liabilities. A good current ratio is typically considered to be anywhere between 1.5 and 3.

A: A higher cash ratio means that a company has more liquid capital available and lower short-term liabilities in need of payment, while a lower cash ratio means that there is a higher amount of liabilities and less cash on hand as an asset. Therefore, it is more desirable to have a higher cash ratio than a lower one.

The quick ratio offers a more conservative view of a company's liquidity or ability to meet its short-term liabilities with its short-term assets because it doesn't include inventory and other current assets that are more difficult to liquidate (i.e., turn into cash).

The two most common metrics used to measure liquidity are the current ratio and the quick ratio. A company's bottom line profit margin is the best single indicator of its financial health and long-term viability.

If your current ratio is high, it means you have enough cash. The higher the ratio is, the more capable you are of paying off your debts.